Middle Market Business Growth Projections on the Decline

Article written by Meghan Daniels and provided courtesy of Axial.net

At the end of last year, an all-time high — 73 percent — of middle market company executives reported that their company’s overall performance exceeded that of last year, according to the National Center for the Middle Market. In Q3 2019, that number was 60 percent, down from 68 percent in Q2, according to the organization’s Q3 2019 Middle Market Indicator report, released last week.

This figure is indicative of the report’s overall findings — while performance is still relatively solid among middle market organizations, growth rates are declining, hiring rates are slowing, economic confidence is wavering, and companies are adjusting their expectations for expansion in the coming year. “Overall, leaders appear to be taking appropriate steps and hedging their bets for the time being, perhaps responding to growing national and global economic uncertainty. As attitudes and behaviors shift toward conservatism, many leaders are focusing internally on ways to cut costs and drive efficiency to ensure they are prepared for whatever the coming months bring,” according to the report.

Here are four takeaways from the National Center for the Middle Market’s Q3 report. For more, read the full report.

1. The percentage of companies adding jobs dips under 50% for the first time in 2.5 years:

For the past 2.5 years, more than half of middle market companies reported adding jobs, vs. 46 percent of companies this quarter. Year-over-year employment growth also fell this quarter vs. Q2 2019, from 6.4 percent to 4.1 percent, and the projected rate of growth for the next year is only 2.5 percent — the lowest number since 2014. Companies with annual revenues under $100 million were less likely to have added jobs than those with revenues between $100 million and $1 billion.

2. Middle market leaders are confident in their local economics — the global economy, not as much:

While 81 percent of middle market executives remain confident in their local economies, the figure for the global economy is much lower at 55 percent. This reflects a major decline from Q1 2018, when the figure was 82 percent. Confidence in the U.S. economy was 76 percent this quarter — lower than the five-year average of 79 percent.

3. Talent management is a persistent challenge:

Even as company’s hiring plans become more modest, today’s middle market companies struggle with retaining workers given low unemployment rates and persistent skills gaps, particularly in certain sectors. According to the report, 55 percent of companies cited talent management as a pressing short-term challenge and 46 percent as a long-term concern.

4. Nearly half of companies are consciously tightening their purse strings:

Forty-six percent of executives said they had “accelerated cost-cutting and efficiency efforts in the last six months.” This is likely tied to declining hiring rates and may lead to a decrease in raises for existing employees as well. In addition, “this suggests that bosses may be more Scrooge than Santa when merit increase time rolls around,” according to the report. These cost-cutting efforts come amid a widening gap between cost and profit expectations — this quarter, middle market executives reported their profit margin growth over the next year as 1.7 percent, compared to reports of 3 percent throughout 2018 and earlier this year.

The data seems foreboding — “this quarter’s report shows the biggest one-quarter drops in revenue and employment growth in the eight-year history of the MMI,” notes the study’s authors. However, they also note “it’s important not to make too much of these downward-pointing numbers,” as they only reflect a quarter’s worth of data and may prove to be an anomaly. Tracking growth and hiring, investment activity, and executive sentiment over the coming quarters will help determine whether this data is an outlier or a true reflection of economic softening.

 

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Ownership Has Its Privileges

Walk down Nashville’s Lower Broadway any night of the week, and you can hear aspiring artists belting out cover tunes from Elton John to Garth Brooks.

In many cases, these musicians come to Nashville to be discovered but pay their rent using the tips they get by playing other people’s songs. Most are lucky to eke out a modest living while the stars they impersonate run thriving empires.

Forbes estimates[1] that Luke Bryan, country music’s highest-paid star last year, earned 52 million dollars on the back of his stadium tour and duties as an American Idol judge and Chevy spokesperson.

What’s going on here? Is Bryan that much more talented than the dozens of artists playing his songs in Nashville every night?

Probably not.

The difference comes down to who controls the product. In Bryan’s case, he owns the music and the personal brand he has created to perform it. The cover artist is just reselling his stuff.

The Value Of Your Brand

The music business can be a helpful analogy in explaining why creating a unique brand is such a big contributor to the value of your company. Acquirers want what they could not easily copy. If you’re reselling other people’s products and services, an acquirer will likely argue that there are probably dozens of competitors driving down your margin next to nothing. Further, they may even conclude that they too could earn a license to resell whatever you’re distributing and will, therefore, place little value in the company you’ve built.

However, if you have something exclusive – a unique product or brand that makes people believe what you do is different – an acquirer will pay more, arguing it is difficult to reproduce what you have created.

If you find yourself reselling other people’s products or services, you can still drive up the value of your business by creating a brand around the way you do it. You could argue that Peloton is just selling a stationary bike. Still, it is the unique company they have created around the bike –including the community of riders that subscribe – that has recently driven Peloton’s value north of $7 billion (almost eight times trailing twelve months revenue at the time of their recent Initial Public Offering).

To drive up the value of your company, own the stuff you sell. If that’s not possible, create a unique brand that makes consumers feel as if you do.

[1] http://www.nashcountrydaily.com/2018/08/14/forbes-list-of-the-highest-paid-country-stars-of-2018-includes-luke-bryan-garth-brooks-kenny-chesney-more/

 

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Middle-Market Dealmaking Continues to Outperform

Article written by Danielle Fugazy and provided courtesy of Axial.net

Middle market deal activity in the first half of 2019 is on pace with 2018’s record-setting figures in respect to both deal count and value. In Q2 2019, buyout shops closed 866 deals for a total of $124.2 billion, representing a year over year increase of 12.9 percent and 15.8 percent, respectively, according to Pitchbook Data.

The middle market continues to dominate the private equity sector. Middle market private equity deal activity (deal sizes between $25 million and $1 billion) comprised 82.4 percent of all buyouts in the U.S., marking five consecutive years. The middle market also made up 69.2 percent of private equity deal value in the first half, higher than any full year figure since 2014, according to Pitchbook.

Add-on acquisitions remain popular among middle market private equity firms looking to add value. In the first half of 2019, add-ons made up 59.5 percent of deal value as well as 68.8 percent of deals closed in the middle market.

“Private equity in the lower middle market remains vibrant and active. Riverside has seen a record pace of deal flow this year, especially in the lower end of the middle market where we focus our investing,” says Jeremy Holland, a managing partner at The Riverside Company. “Entrepreneurs have a plethora of choices today, whether it be full liquidity or growth capital. We are offering an array of private capital solutions to entrepreneurs, including non-control solutions such as structured equity and non-dilutive growth capital to B2B SaaS companies. It’s what makes sense today.”

Surprisingly, exits showed a decline in the first half of 2019. In the second quarter, middle market exit activity saw GPs exit 176 companies for a combined value of $31 billion—a decline of 19.4 percent. Although exits were down overall, there were five private equity-backed IPOs in the second quarter. The largest middle market exit of the quarter was Change Healthcare’s $557.1 million IPO, which had a valuation of $981.2 million. The company was initially taken private by The Blackstone Group and Crimson Ventures in 2011. In 2016, the company was merged with McKesson’s technology solutions business. What’s more, Pitchbook anticipates an uptick in IPO activity and corresponding IPO value going forward.

“We all know that add-ons can lower blended purchase price multiple and add scale, and they remain one of the most powerful levers into not only building bigger but better companies. Add-ons offer geographic balance as well as supplier and customer diversity. And oftentimes, they add intellectual property such as brands and patents. Perhaps most importantly, add-ons can bring tremendous human capital adding depth to our management teams,” says Holland.

Middle market fundraising figures were down in the second quarter, with $17.2 billion raised across 19 funds. Fundraising value in the first half of 2019 declined by 19.5 percent from the first half of 2018. Nineteen funds raised in Q2 is the lowest quarterly figure since Q3 2012. Some of the more notable funds raised include Silver Lake’s first mezzanine fund, Silver Lake Alpine Funds, which closed with $2.5 billion and is focused on making non-control equity and credit investment in technology and technology-enable companies. One first-time equity fund closed in Q2, Gainline Capital Partners, which held a final close with $155 million in May. Grain Communication’s Opportunity Fund II also closed during the quarter with $900 million. The firm focuses on investments in the global communication sector.

Middle market funds are a declining portion of all U.S. funds in terms of value as mega firms swell in size.

 

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What to Expect in an M&A Letter of Intent

Article written by Meghan Daniels and provided courtesy of Axial.net

The letter of intent (LOI) is an important step in most M&A transactions. The LOI allows buyers to signal that they’re serious about a potential deal and to make sure that their vision lines up with the seller’s before they spend significant resources on a full due diligence process.

Here are the answers to four frequently asked questions about the LOI.

1. What does the LOI include?

A letter of intent serves in some ways as a preview or summary of the deal terms that would be expected to appear in the purchase agreement down the line. LOIs typically vary in length from about two to 10 pages, depending on a number of factors. Some argue a shorter LOI can help speed up the negotiating process as it centers the conversation around the most important elements of the deal: if there’s not agreement there, the logic goes, there’s no need to discuss other factors. Others prefer to address all potential issues upfront to avoid any surprise dealbreakers later on.

Here are some of the typical terms you’ll see in an LOI, though of course this varies depending on the deal.

  1. Deal Structure: Is the transaction a stock or asset purchase?
  2. Consideration: What are the forms of payment? This can include cash, stock, seller notes, earn-outs, rollover equity and contingent pricing.
  3. Closing Date: What is the projected date for closing the deal?
  4. Closing Conditions: What are the tasks, approvals, and consents that need to be obtained before or on the closing date?
  5. Exclusivity Period: This is typically a binding clause requested by the buyer, who wants to ensure that sellers are negotiating in good faith. It’s typical for buyers to request an exclusivity period from 30-120 days, while sellers will typically want as short a period as possible.
  6. Break-up Fee: This clause is also typically binding, though break-up fees are less common in the lower middle market. In larger deals (>$500MM), break-up fees of approximately 3% are typical.
  7. Management Compensation: Which members of the senior management will stay on? Who will be provided equity plans? This aspect of the deal may be vague at the LOI stage before due diligence has been conducted.
  8. Due Diligence: How will due diligence will be conducted? This includes the nature of information that will be disclosed and the manner in which it will be disclosed.
  9. Confidentiality (Binding): Both parties have likely already signed an NDA earlier in the process, but this clause further ensures that all discussions regarding the proposed transaction remain confidential.
  10. Approvals: Does the buyer or seller need any approvals (e.g., from a board of directors, regulatory agencies, customers) to complete the transaction?
  11. Escrow: This may not appear until the purchase agreement, but sometimes the buyer will include summary terms of their expected escrow terms for holding back some percentage of the purchase price to cover future payments for past liabilities.
  12. Representations and Warranties: This also may not agree until the purchase agreement, but if there are contentious or non-standard terms the buyer may include them in the LOI.

2. Is an LOI binding?

LOIs are generally non-binding, though sometimes there will be terms that are specifically called out as binding, e.g., exclusivity periods or break-up fees. It’s important to note, however, that in certain cases courts may interpret letters of intent as binding documents if the buyer and/or seller treats it as a contract. Still, sellers shouldn’t expect that the terms outlined in the LOI will necessarily be the final terms offered by a buyer. Buyers are looking to portray themselves in the best possible light at this point in the deal process, and have not yet conducted full due diligence and therefore don’t have a complete sense of the business’ risk factors that may impact their ultimate purchase price and terms.

3. Are LOIs mandatory?

No. It’s not unheard of for buyer and seller to skip over the LOI and go straight to the purchase agreement. However, an LOI can be useful for a number of reasons. It helps ensure that buyer and seller have similar (or at least similar enough) expectations around deal structure, scheduling, and other big concerns. It also means that any potential deal-breakers come up earlier in the process, so that the parties can either a) stop the transaction process before significant resources are spent on due diligence and drafting deal documents or b) figure out a resolution sooner. The letter of intent also is a nice way to ensure that seller and buyer are on the same page about how due diligence will be conducted. In addition, the LOI’s terms serve as important protection for all parties in a deal (e.g., exclusivity periods product buyers, while break-up fees protect sellers). Creating a shared vision of the future transaction means that there are fewer unpleasant surprises down the line and can make the overall deal process run a lot more smoothly.

4. What happens after the LOI is signed?

The next stage is typically due diligence. The buyer may have been conducting informal due diligence already, but the formal process begins now, and the seller will be expected to provide detailed financials and customer information along with other requested materials. These findings will inform negotiations down the line as buyers aim to lower their risk and sellers look to optimize purchase price and terms. At the same time that buyers are conducting due diligence, they also begin to plan for integration — doing so early on helps buyer and seller think through potential roadblocks and concerns and address those prior to the deal close. The final stage, of course, is drafting and signing the purchase agreement, which may require significant negotiation to get to a place where both buyer and seller are comfortable.

 

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Being Stingy With Your Equity

It can be tempting to offer shares in your company to finance its growth. These days, there are plenty of investors chasing promising new companies and, in today’s tight labour market, employees are getting more brazen in their demands for equity-based compensation. However, using equity as a form of currency dilutes your position and may not be necessary with a pinch of creativity.

How David Hauser Bootstrapped His Way To a 9-Figure Exit

David Hauser has been an entrepreneur for most of his life. He had a number of small money-making ventures in high school and studied entrepreneurship at Babson College. He started a web design business after graduation, followed by an internet advertising company.

Through his early experiences in entrepreneurship, Hauser discovered that one of the most frustrating parts of starting and growing a small business was acquiring a phone system. Back in the late 1990’s, big companies used a PBX system to route calls throughout a switchboard, but a PBX system was prohibitively expensive for most small companies to acquire and maintain.

Hauser and his friend Siamak Taghaddos imagined a “virtual PBX” which allowed small business owners to leverage the internet to create a phone system without having to buy any of the hardware. They built a crude version of the technology, named their new company GotVMail (later rebranded as Grasshopper), and launched in 2003.

By 2004, they had acquired their first few customers and could see that in order to scale they would need to buy servers and a lot of advertising to drive demand. The venture capital markets were starting to thaw after the dot com bust of 2001 but Hauser chose not to raise venture capital. Instead, they clung to their equity and bootstrapped their little business.

Instead of ordering servers from Dell, Hauser found a local computer company and sold it on his vision for the future. Hauser asked the owner to make a server for him below cost arguing that if Grasshopper achieved its vision, Hauser would soon buy many more. When Howard Stern moved his show to satellite radio, Grasshopper offered to support Stern’s new medium in return for major concessions on the price of a commercial.

Grasshopper also offered discounts if customers paid for a year’s worth of service up front, effectively turning its customers into financiers of the business. Despite its growth from start-up to $30 million in revenue in just 12 years, Hauser was able to retain the majority of the equity in his business, which he sold to Citrix in 2015 for $165 million in cash and $8.6 million in Citrix stock.

As the story of David Hauser illustrates, owners who focus on value building will guard their equity like a greedy child hoarding a bag of Halloween candy. Rather than selling their friends and family cheap shares or giving every new employee options, they use other forms of financing to start and grow their business.

Rather than thinking of your shares as a currency to distribute lavishly, consider your stock as the essential ingredient to building value.

 

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You’ve Received an Unsolicited Offer to Buy Your Business — Now What?

Article written by Ari Fuchs of The DAK Group and provided courtesy of Axial.net

Nearly 1 in 3 business owners report receiving an unsolicited offer to buy their business in the prior twelve-month period. If someone approached you with an offer to buy your business, would you know what to do? You’ve probably said to someone, or thought, something along the lines of “my business isn’t for sale, but for the right price I’d consider it.”

You may be flattered because the number may be higher than you imagined, and you may respond positively. But how do you know for sure? Even if your first reaction is a resounding “yes,” and you want to start the process, is that the prudent approach? It’s unlikely that you would ever make a decision about your business with information from only one source.

There are a number of questions to consider. What is your business worth? What is the right price for my business? What are similar businesses selling for? Could there be other interested buyers out there? How do you negotiate a better deal? What kind of partner will this company be? What do I want out of my business anyway at this point?

Business owners will be tempted to begin the process on their own for many reasons.. It’s certainly do-able to take the DIY approach. But the primary risk associated with going it alone is that you get in over your head in a short period of time. A sale process is a substantial undertaking which can often be overly distracting to the ongoing growth and success of your business. What is likely the largest financial decision of your life is not a time to learn on the fly. Often the acquirer has gone through the process many times – they are perhaps experts at doing deals and sometimes speak a different language than the business owner. It is for these reasons that a business owner might consider assembling a team of experienced advisors to assist throughout the process and to help evaluate the situation. Usually, this team is composed of an M&A advisor, your lawyer, your accountant, and possibly a wealth manager.

If you decide to assemble a deal team to help you with the process, here are four things your team of advisors will help you with:

1. Figuring out if the offer is fair and reasonable

Your M&A professional should be able to help you understand the value of your business and consequently whether the offer you received is fair and reasonable. The specifics of your business can really impact its value, making it important for you to understand the way an investor is evaluating your company’s worth. If the acquirer is strategic, then you need to understand how your business will impact the value of their business to negotiate the highest possible purchase price and most favorable terms. Even if an initial offer is deemed fair and reasonable, your investment banker should help you maintain the upper hand and push a buyer to give you the best value and terms by threatening or even proceeding to create a competitive bid process. The presence (or even threat) of another buyer may push the acquirer to adjust their offer.

2. Managing the flow of due diligence information

It’s important to employ good judgment about what information you share. How can the information be best positioned to amplify the strengths of my business? At what stage should you be sharing sensitive competitive information about customers and employees? The answers to these questions can have serious implications on how a buyer views and values the business.

3. Negotiation technique and approach

Repeat corporate or private equity buyers are generally experienced negotiators. How can you ensure that you’re not being out-negotiated and leaving money on the table? This is where high quality M&A advisors can earn their fee. The banker can also play the role of bad cop when you need to be insulated from a difficult negotiation point to ensure that you preserve the principal-to-principal relationship with the buyer. This is particularly relevant if you expect to play an ongoing role in the management of your business post-closing.

4. Allow you to focus more time on running the business.

Selling your business is time consuming for a business owner even when they have a good deal team supporting them. Without a deal team, it can become all consuming. Having the capacity to focus your time on running your business during a sale process better ensures the likelihood of a closed transaction. When businesses underperform during a period of scrutiny like this, it can break the deal.

The sale process — from negotiating and accepting an offer, getting through due diligence, and finally closing — has its ups and downs. You can benefit from experienced advisors in the process to act as a sounding board and to provide you with coaching and recommendations throughout the process.

Whether you are considering selling your business now or at some point in the future, you should always be prepared for that phone call and have a plan for how you will respond. Understand the value of your business in today’s market. Be aware of what enhances or detracts from the value of your business. Work with advisors who are knowledgeable and can help you navigate through the process of qualifying and validating a buyer.

You have invested years, possibly decades of your life building a successful business. When the time comes to sell the business, being prepared matters.

 

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The Fatal 5 Reasons Why Your Business Won’t Sell

By Ryan Jorden, VR Business Brokers – Managing Partner

You’ve been thinking about selling your business for a while and now you’re finally ready to pursue a sale. But is your business prepared to withstand the scrutiny of a buyer and their professional advisors? If you haven’t been through this process before, then you may be unaware of some issues present in your business that a savvy entrepreneur is looking out for and seeking to avoid. These barriers to selling will undoubtedly show themselves during a buyer’s due diligence and likely derail your deal. So let’s take a look at some of the common issues that arise so you can start working on them in order to maximize your value in a successful sale.

1. You aren’t mentally prepared for the process

You thought you were ready, but now that you’re discussing it in depth with your trusted broker you realize that you have no plan for your life after the sale. Your identity and self-worth are very closely wrapped up in your business, or perhaps you’ve worked so hard at growing your business that you simply didn’t have much room for a social life or hobbies. What are you going to do with all of that free time? The great unknown looms large and you’re getting cold feet at the prospect of reinventing yourself.

This is an opportunity to draw up some goals and gain a clearer understanding of how your life will change and benefit from the sale of your business. Maybe you desire to spend more quality time with your spouse or grandchildren, finally enjoy some uninterrupted holidays, or pursue a completely different business venture. Write it all down and start filling in the blanks until you feel it becoming tangible. Because it’s crucial that you’re fully committed to the transition both emotionally and mentally.

If you’re on the fence, then your business will suffer in the meantime, your broker will get frustrated trying to drag you along and any buyer you meet is going to confuse your reluctance of selling with disapproval of them.

2. You have unrealistic expectations of the timeline required

If you thought you could walk away six months after the day you decided to sell, the reality is going to be a difficult adjustment to make. Especially if you’re already mentally burned out or suffering from health issues. It’s better that you know now what it all entails so you can realistically prepare yourself to do what it takes to ensure a successful transition.

So how long does it take to sell your business through a brokerage? On average you’re looking at nine to twelve months to locate a suitable buyer, however, some businesses may even take up to two or three years. The length of time will often depend upon the type of business you have, how much financing you’re willing to extend, whether or not your price is market friendly and who you’re using to represent your business for sale.

It may also take a couple of years of pre-sale planning to resolve ignored or unknown issues or to implement a tax friendly strategy. And depending on your business, you may be required to stick around for one or two years to play a key role in the transition.

The best advice I can give anyone is to start planning your exit today, regardless of when you think you’re going to sell.

3. You don’t have the documentation required

You have to be prepared to disclose a fair amount of information to a serious buyer in order for them to gain the confidence required to move forward. I’ve had numerous business owners approach me over the years with a request to help them sell their business, however they weren’t even willing to share their financials with me. I simply won’t allow a buyer to potentially risk their life’s savings on a mystery box, so these are business owners I will not work with.

What are the basics you should start getting ready today? In addition to a copy of the lease, current inventory status, itemized list of furniture, fixtures & equipment, you will also require accountant prepared financials for the past 3 to 5 years. A serious buyer needs to understand the revenues and expenses of a business, as does their accountant and lender. Not having accountant prepared financials will unnecessarily introduce a level of risk to the buyer that makes it impossible for a business to sell.

The more detailed and confidential information such as client lists and existing business contracts aren’t made available until the period of due diligence after an accepted offer is in place, however, you need to have it ready to go. Delays will kill your deal by eroding the confidence of your prospective buyer while also giving them time to find another option.

The bottom line is don’t expect a buyer to simply take your word for anything, they’re going to require proof.

4. You have internal issues that haven’t been fixed

The buyer of your business isn’t going to pay you top dollar if they have to come in and sort out a mess. They want to be able to plug themselves or a manager in and start immediately growing the business.

Common issues we encounter are inventory management concerns, missing or outdated systems & processes, decreasing revenue, poor earnings, a cash component that’s throwing off the expense to revenue ratios, a missing safety program, or the lack of key staff in place that can assist the new owner after your departure. If you’re doing three roles and all of your customer relationships are with you personally, get a manager in place and train your customers to call the business instead of your cell.

These are all matters that can be fixed, however, they can take a varying degree of time to address and correct. Make a list of all your known issues and start working on it. You may also want to consider hiring a small business consultant or contract CFO who can discover additional unknowns and assist you in improving them.

5. You are asking too much

An ill-informed expectation of value is going to cause you frustration as you watch buyer after buyer pass you by. Since they’re primarily purchasing your cash flow, the package it comes in is often less important to many buyers than the payback period, risk and ROI. An experienced entrepreneur won’t pay for your location, client base or name recognition if it’s not translating into profit.

Get a professional business valuation completed immediately so you can set your expectations of fair market value. This will also help your broker in establishing and justifying the value of your business to a buyer, their accountant and the bank.

If you’re asking too much then you’re not going to sell, and if you’re asking too little then you’re cutting yourself short and leaving good money on the table.

If you’re thinking of selling your small business, we would be pleased to answer your questions and assist you with starting this process. Let us put our expertise to work for you!

 

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When Does an MBO Make Sense?

Article written by Danielle Fugazy and provided courtesy of Axial.net

KLH Capital is a lower middle market private equity firm that specializes in making three types of investments: management buyouts (MBOs), recapitalizations, and family/generational successions. Founded in 2005, KLH has completed over 35 platform investments. Axial’s Middle Market Review sat down with James Darnell, a partner with the Tampa, Florida-based firm, to talk about when and why MBOs make sense for sellers and buyers, and other types of transactions that are happening in the lower middle market today.

What is a management buyout?
An MBO is a fancy term that private equity guys like to use to describe a situation when the management team that is currently running a business buys out some or all of the business’s existing shareholders, and in the process obtains some ownership in the company for themselves.

MBOs are really effective for management teams who have created a lot of value in the business and established themselves as the leadership of the company. These teams already understand their customer base and their market, and have demonstrated successful leadership skills. They make for good owners! They have created a great business, but they haven’t been able to fully enjoy the financial benefits as they aren’t owners themselves. To complete an MBO, the management team works with a private equity firm like ours to facilitate a liquidity event for the current shareholder(s), and through that transaction, the management becomes shareholders themselves, alongside us.

What are the advantages of completing an MBO?
The shareholder(s) who are selling the business or realizing liquidity are able to get fair market value for their business and ensure the company remains in the hands of people they already know and trust. Sellers also often feel they have done the right thing by both their employees and management teams when they sell to management.

For the new private equity investors, MBOs are a chance to invest in a deal that has a lower amount of risk than a typical deal because they are backing an incumbent management team that has already demonstrated they can lead that particular company. Lower risk for an investor is always a good thing.

The managers that are participating get ownership in the business going forward. They also continue to run and grow the business as they have been. Because of this ownership event, employees are usually happy and remain motivated. Employees’ biggest fear when there is a sale is that the new owners will try to steal the business or change the culture of a company. In the case of an MBO, management and employees should already share the same vision and values.

Are MBOs a popular strategy today?
There are many baby boomers who have enjoyed the growth of their businesses and would like to pursue retirement. The MBO option allows sellers to do something a little different from a regular sale or a recap. With a traditional recap, sellers will receive partial liquidity, but likely be asked to stick around for three or four years and then get a second bite at the apple. For business owners who want to step back, an MBO will speed up that process.

How does an MBO differ from an Employee Stock Option Plan (ESOP)?
With an MBO, the business owner is going to be able to realize more of the business’s value in cash immediately and can direct specific ownership amounts to key employees. With an ESOP, the seller will carry a note that pays out over time and they will likely need to personally guarantee the third-party financing to bond them to the business. An MBO is a clean break at full valuation.

How does KLH find businesses that want to participate in MBOs?
We find our business through a network of referral sources that we have developed over 15+ years. We network on a daily basis and help business owners understand their liquidity options and how private equity can play a part in their growth strategy or financial stability, or how we can help address any financial problems they may have.

Recaps are a big part of your business. When does it make sense to do a recap?
We frequently invest in recap transactions. In fact, we do more recaps than MBOs. They are similar transactions. The question is how involved the seller wants to be going forward? If you have an owner who is in full control, it’s hard to do a management buyout if there isn’t a management team to step in. If the seller can totally remove themselves, then an MBO may be a viable path for the seller to cash out fully.

How do generational transitions differ from recapitalizations and MBOs?
They are similar to both MBOs and recaps. Generational transitions happen when a younger generation of a family business wants to take over from prior generation(s). Often, the younger generation doesn’t want to mortgage the company to put all the money in the prior generation’s pockets. Additionally, it’s very hard for families to navigate the trickier parts of these types of transactions, like the equity and debt raises and the risk allocation between the “buyers” and “sellers.” It’s too personal and familial relationships are more important. A third party can usually provide the liquidity and help get the transaction completed on a more arms-length basis.

 

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A Tale of Two Franchisors and Their Resale Process

Our Dallas, TX office recently engaged two different franchise brands for reselling existing locations within the respective franchise systems. The franchise brands are from completely different industries, but have the following common characteristics:

  • Both franchisors have been in business for over 30 years.
  • Both franchisors have a history of incredible growth in number of units as well as average unit volume.
  • Both franchisors are well-respected brands – having many times over the past several years been designated as the leader in their respective business categories by a variety of franchise ranking publications.

This is about where the similarities end! During the engagement process we became familiar with each franchisor’s procedures and personnel that support the franchisees in executing their exit strategies. And, the differences couldn’t be more pronounced!

Franchisor A

  • Provides franchisees with a “Resale Manual”, which guides the franchisee through the resale process, including checklists for Buyers and Sellers.
  • Has specific qualification requirements for buyers that are clear to everyone involved in the process.
  • Offers franchisees guidance on their business valuation using historical data from actual past transactions within the franchise system.
  • Advises the franchisee on any décor or system upgrades that will be required during the resale process.
  • Assists franchisees with marketing their resale opportunity through relationships with 3rd party business brokerage firms.
  • Speaks directly with prospective buyers early in the process to reinforce the benefits of the brand and guide the potential buyer through the franchisor resale procedures.
  • Will convert potential “new franchise prospects” to a resale opportunity if the resale characteristics are of interest to the buyer.
  • Offers educational classes for franchisees regarding Exit Strategy Planning at their annual conventions.
  • Provides flexibility with regards to training deadlines and timelines for both buyer and seller to ensure timeliness in concluding a transaction.
  • Provides buyer and seller with template agreements (LOI and Purchase Agreement) to streamline negotiations, but with clarification that both parties should secure the appropriate legal advice.
  • Assigns specific corporate personnel to assist franchisees throughout the process. Executive personnel available for additional consultation.
  • Brokers have easy access to corporate personnel to address any issues during the process – reinforcing that the goal is to find a qualified buyer and support the exiting franchisee’s desire to sell and achieve a reasonable return on their investment.

Franchisor B

  • No guidance was offered directly by franchisor, only to emphasize their right to approve any transfer of the franchise.
  • Uses the “Area Developer” system to support the “local” franchisee resale process. The franchisor did not want to assess or communicate with a prospective buyer until such time as the buyer had completed a review process with the Area Developer, and a Purchase Agreement was fully executed between buyer and seller.
  • The developer would only communicate with the franchisee, not a broker. A buyer candidate could not meet the area developer prior to a one-time per month educational “seminar” regarding the franchise system.
  • Prospective buyers were told that décor and equipment upgrade requirements would be enforced at some point in the very foreseeable future. However, various prospective buyers over a six-month period were told of costs ranging from $15,000 to $80,000 for the upgrades – with the stipulation that the upgrade requirements were still not final! Advertised costs to open a new franchise location range from a low investment of $100,500!
  • It could take 3 – 6 months, as quoted by the area developer, for a potential buyer to be vetted and officially approved by the franchisor, at which time the buyer would still need to complete the franchisor training program prior to closing on the transaction.

Our experience in working with Franchisor B was extremely frustrating. We submitted five candidates for approval that had agreed terms with the seller. Four of the five candidates were not approved by the area developer – with no reason given for any of the four declines. One candidate had a net worth in excess of $5M, and all candidates exceeded the financial requirements for “new” franchisees as advertised by the franchisor. Two of the candidates had previous food industry experience, which happened to be the industry involved. The 5th candidate decided to terminate the transaction due to delays in the approval process. All five of the candidates were disappointed in the process, and now have a negative view of the brand. I doubt seriously they will ever be customers of the brand in the future.

During this same time period we concluded multiple transactions with Franchisor A. We submitted only one buyer candidate that was not approved by the franchisor – the finances were simply too tight for the franchisor to have comfort with the deal, and the candidate was appreciative of the professionalism shown during the review. I think it is safe to say the candidate will continue to be a fan of the brand and may at some time in the future be a viable buyer.

Now for the interesting part! Over the last 4 years, the franchisors have experienced very different results in the evolution of their business models.

Franchisor A

The total number of domestic stores operating at the end of calendar year 2018 indicates a net growth of 21% over a four-year period. The total network wide revenue increased 23% during the same four-year period.

Franchisor B

Total number of domestic stores operating at the end of calendar year 2018 indicates a net decline of -4% during the same four-year period. The total network wide revenue declined -5% during the same four-year period.

Summary

There can be any number of reasons why one franchisor achieves continued growth while another experience decline. I’m not suggesting that the franchise resale process is the sole reason! However, based on our experience it certainly doesn’t surprise me to see the results of these two brands.

Franchisors often use cliché terms like “We want the franchise sale to be a win – win”, or “Be in business for yourself but not by yourself”. Some franchisors validate these sentiments by the way they support their franchisees in every aspect of their business life. Unfortunately, other franchisors do damage not only to their brand but to the entire franchise industry by not living up to the very talking points by which they sell new franchises. And, selling new franchises is all some franchisors are interested in, rather than also assisting franchisees with a smooth and satisfying exit from the brand after many years of brand ownership.

Assisting franchisees with a franchise resale is the right thing to do, but also the smart thing to do. Assistance will likely result in higher resale values, which will help validate the business model for those buyers considering opening a new franchise. It’s also beneficial at times to have new energy enter the franchise brand. And often, a new owner is needed to turn a struggling location into a successful one.

Perhaps franchisors should live by the credo of “assisting a franchisee to be as happy with the franchise brand on the day they exit the business as they day they purchased the business”.

 

About the Author
Larry Lane is the owner of VR Business Brokers of Dallas, TX, which is part of the worldwide franchisor organization that has been servicing small to medium size privately held companies since 1979. Larry spent 21 years as an executive with FASTSIGNS International. During his tenure the company grew from 15 stores to 540 stores operating in six countries. Larry has been a franchisee in the VR Business Brokers network for the last 10 years. For more information about VR Business Brokers of Dallas, please call 214-733-8282, email llane@vrdallas.com or visit www.vrdallas.com

 


Run Your Private Company Like It’s Public

Small businesses often operate as if their sole purpose is to fund the owner’s lifestyle, but the most valuable companies are run with financial rigor. You may be years from wanting to sell, but starting to formalize your operations now will help you predict the future of your business. Then, when it does come time to sell, you’ll fetch more for what you’ve built because acquirers pay the most for companies when they are less risky. There’s nothing that gives a buyer more confidence than clean books and proper record keeping.

Jay Steinfeld is a great example of how to run a business like a public company. Steinfeld studied Accounting at the University of Texas and joined KPMG after college. His wife owned a small retail store selling blinds and window treatments. The store was successful, but by 1994, Steinfeld had noticed a little Seattle-based outfit that was trying to hawk books online. This company with the peculiar name “Amazon.com” started to succeed in selling books online and Steinfeld wondered if he could get consumers to buy blinds online.

Soon after, Blinds.com was born.

Unlike many of the first-generation online companies that were run with little financial controls, Steinfeld grew Blinds.com like an accountant. He was determined to run his business with the same rigor as a publicly listed company. He built an experienced management team and took the unusual step of assembling an outside board of directors even though Blinds.com was private and Steinfeld owned all of the stock.

The board met quarterly and each of Steinfeld’s senior managers were asked to prepare and deliver formal presentations to his board. Steinfeld hired a big four firm to complete a full audit of his financials each year even though all he needed to satisfy Uncle Sam was a simple tax return.

By 2014, Blinds.com had grown to 175 employees and, at more than $100 million in revenue, was the largest online retailer of blinds in America. Even though Home Depot had close to $90 billion in sales at the time, Blinds.com was outperforming them in its tiny niche, which – coupled with their fastidious bookkeeping — made Blinds.com absolutely irresistible to Home Depot. On January 23, 2014, Home Depot announced its acquisition of Blinds.com.

Running your business like it’s public will make it more predictable as you grow and ultimately a whole lot more attractive when it comes time to sell.

 

Is your business creating maximum value?

Complete the “Value Builder” questionnaire today in just 13 minutes and we’ll send you a 27-page custom report assessing how well your business is positioned for selling. Take the test now:

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